Before you sign up for disability insurance coverage, you may want to know if it is taxable in Canada.
Disability benefits may or may not be taxable. Payments received from individual and self-employed policies are tax-free, without exception. Group plans, however, are a different matter. If the plan is funded by employer paid premiums, whether partially or completely, the benefits are taxable.
What Is Disability Insurance?
Disability coverage is a legally-binding contract between you and the insurer, in which the insurer promises to pay a fixed monthly benefit if you cannot work because of illness or injury. A Disability plan protects your most valuable asset — the ability to earn — and as such is worth considering.
Short-term disability and long-term disability are the two main types of disability plans. Short term disability insurance protects you against temporary loss of income due to an illness, injury, or psychological disorder. The payout period is usually a few weeks to six months.
Long-term insurance commences after your short-term disability coverage runs out (if you have a policy). Long term disability insurance provides a steady stream of monthly income for a much longer period of time -usually years, or even decades — if an injury or illness prevents you from earning a paycheck.
Disability plans have a waiting period, which is a brief period of time you must wait after becoming disabled before the benefits become payable. The waiting period for short-term disability insurance policies is 0-7 days, and for long-term disability plans it is 90-120 days.
Many disability policies provide both short-term and long-term coverage; others are strictly either short-term or long-term. Long-term disability insurance pays monthly benefits until the payout period expires or until you are fit enough to resume work. You do not need to submit any bills to collect the disability benefits and can use the funds as you choose. The monthly payout is usually anywhere between 60% and 80% of your gross income before disability.
Are Disability Coverage Benefits Taxable?
Whether or not you will be taxed on disability benefits depends on who pays the premiums. In this section, we will discuss the tax rules for both long-term and short-term disability insurance.
Long-term Disability Insurance
Premiums paid out of pocket
When you pay the premiums out of pocket, the long-term disability insurance benefits are not taxable. The monthly benefit payments are not counted as your income; instead, they are considered compensation for the loss of income resulting from disability. You bought the policy and paid the premiums. As far as the Canada Revenue Agency is concerned, the money was already taxed when you received your salary.
Because you paid the premiums for your policy with after-tax dollars, the long-term disability benefits are not taxable.
The Canada Revenue Agency treats a self-employed plan the same way as an individual policy. That is to say, the monthly payouts are not regarded as your earnings and as such are not subject to income tax.
Employer pays part or all of the premiums
Some Canadian employers offer long-term disability benefits to their employees as part of the employee benefits package. This is where things get a little complicated.
If the employer funds all the premiums and does not deduct these payments from your pay, any money you receive is considered a taxable benefit. Therefore, you would expect to receive a T4 form from your employer.
If the employer deducts premium payments from your pay, the long-term disability benefits are not taxable.
If you are sharing the insurance cost with your employer, you will pay tax on the portion of the long-term disability benefits paid by your employer. For example, let us say you and your employer are splitting the cost 50-50. In this case, 50% of the disability benefits will be taxable. For example, if you receive $50,000 in the form of disability benefits in a year, you will pay tax on $25,000.
Short-Term Disability Insurance
Premiums paid out of pocket
If you have bought short-term disability coverage not related to your workplace, any disability benefits you receive will be tax-free. That is because the premiums were paid with after-tax dollars.
Self-employed professionals do not have access to group disability benefits. Therefore, it is all the more important for them to create a robust financial safety net to protect themselves from life’s unexpected events. For taxation purposes, a self-employed policy is no different than an individual plan. Therefore, any short-term disability benefits that you receive are not taxable.
Employer funds the premiums
When the employer pays the premiums, the short-term disability benefits you receive are considered as taxable income, unless these payments are deducted from your salary.
How Do I Know if My Disability Earnings are Subject to Income Tax?
To know if your disability income is taxable, find out which type of insurance policy you have. If yours is a personal disability plan, the benefit is tax-free since you are paying the premiums with after-tax dollars.
If you have a group disability policy, determine who pays the premiums. The benefit is not taxable if you are paying all the premiums out of pocket.
If your employer pays all or any portion of your premiums, the benefit can have income tax applied to it. If your employer funds 100% of the insurance premiums, the entire disability benefit amount will be subject to income tax. On the other hand, if you and your employer share the cost of coverage, you will pay tax on the portion of the benefits paid by the employer.
Your insurer will inform you if your disability benefits are taxable, the insurer is likely to withhold the tax before issuing benefits.
Is the Canada Pension Plan (CPP) Disability Benefit Taxable?
Yes, the CPP Disability Benefit is taxable. Apart from private disability insurance, eligible Canadians can receive financial assistance from the CPP Disability Benefit in the form of a monthly payment. If this money is your only taxable income, expect the tax implications to be lower on account of the basic personal tax credit on federal and provincial taxes.
To be eligible for CPP Disability Benefit, you must meet the following conditions:
- You must be under 65 years of age.
- You must have a severe and prolonged disability that prevents you from working.
- You must have made sufficient contributions into the CPP.
Are Employment Insurance Benefits Taxable? Also Workers’ Compensation?
Apart from CPP Disability Benefit, other types of disability coverage available from the government are Employment Insurance and Workers’ Compensation. Like the CPP Disability Benefit, Employment Insurance sickness benefits are taxable. However, Workers’ Compensation, which provides financial assistance for work-related illness and injuries only, is not taxable.
Do You Have to Pay Tax on the ‘Return of Premium’ Benefits?
You can add various insurance riders — usually for a small extra fee — to your policy to customize it according to your needs. One such add-on is the ‘return of premium’ rider. This rider pays you back all or some of your premiums if you never file a claim. The cost of the return of premium rider — and other add-ons — is rolled into your premium rate.
Generally speaking, only individual insurance policies are customizable. Since the monthly premiums of your individual policy are paid with after-tax dollars, the ‘return of premium’ benefits are not considered as taxable income.
Is Disability Insurance Worth It?
Disability insurance is buying peace of mind. If you have disability coverage, you know you will receive financial assistance if you ever lose the ability to work due to illness or injury. The risk of suffering a disability is greater than many people think. Research shows that one in every five Canadians aged 15 and over has a disability. How will you support yourself or your family if you become disabled and cannot work? A policy significantly reduces the risk of financial setbacks if you become seriously ill or are seriously injured.
If you have an individual plan, the monthly payments are tax-free because the premiums are paid with after-tax dollars. The same applies for a group disability plan that is 100% funded by you. However, if your employer funds part or all of the premiums, benefits are taxable.